How down payment requirements impact house prices

More borrowers qualify of down payment requirements are low, but those buyers are weaker, so the housing market is less stable.

Large down payments are the bedrock of the housing market because large down payments preserve home ownership, reduce volatility in the market, and reduce the risk to our financial system. The only people who oppose them are realtors and originate-to-sell lenders who see down payments as an impediment to profits and left-wing housing advocates who see down payments as a barrier to putting unqualified borrowers into houses.

Down payments preserve home ownership because people who’ve put down large down payments rarely default. In purely economics terms, people shouldn’t consider sunk costs like down payments in their decision making; however, homeowners do. People simply don’t walk away from properties where they’ve put a lot down, even if they’re deeply underwater. The decision is more emotional than logical, but coupled with the emotional desire to “own” these two forces prevent most people from strategic default even when that option is the best available to them.

There is no way to accurately measure how much skin in the game motivates people to stay and pay. Everyone knows it’s important, but with no way to accurately gauge how much is required, the forces demanding little or no down payment are winning — and for good reason — New down payment requirements could crash housing again. Unfortunately, completely eliminating down payment requirements leaves us with borrowers putting no skin in the game, and quite frankly, that’s a horrible idea.

A high down payment requirement greatly reduces the potential buyer pool whereas a low down payment requirement greatly increases it. This basic fact is why lenders and their lobbyists are working so hard to get down payment requirements lowered or eliminated. Any down payment requirement is an impediment to doing more business. In fact, if down payment requirements were reduced to zero, that barrier to home ownership would be effectively removed. Lenders tried that during the housing bubble, and it was a disaster. Lots of people who didn’t have any savings — or any sense of financial responsibility — took lenders up on their generous offers for free houses. This was a major contributor to the housing bubble and bust, and the resulting losses cost lenders — and taxpayers — billions.

For lenders and investors in mortgage-backed securities, large down payments provide a buffer that minimizes their losses if borrowers do default. Any down payment of 10% or more allows the borrower to sell, pay closing costs and commissions, and fully repay the loan. Down payments of 20% or more gives the lender a buffer of 10% in cases prices decline while the borrower owns it. Price drops of 10% or less are possible in a weak economy even if lenders don’t inflate a bubble. Large down payment requirements serves borrowers, lenders, and ultimately taxpayers who end up subsidizing and backstopping both parties. It doesn’t serve the short-term desires of originate-to-sell lenders, and implementing high down payment requirements will impact the efforts of lenders to reflate the last bubble, but for the greater good, down payment requirements must be at least 10% with 20% being preferred.

Down payment requirements

Down payment requirements have traditionally been very high. During the 1920s, interest-only loans with 50% down payments were the norm. Very few people owned their houses. By the 1950s, conventionally amortized loans with a 30-year term and 20% down payments became the norm, and house prices rose significantly from the bottom of the Great Depression to the 1950s due to the increased use of leverage in real estate.

That is the end of the road for financial innovation. All attempts to tinker with the stability of conventional financing have failed because they are all Ponzi Schemes. People must have a reasonable expectation of paying off a loan in their lifetime. Multi-generational debt is frowned upon here in the United States, so any term beyond 30 years really doesn’t make sense. If borrowers feel like they will never pay it off, they will not try, and they fall into Ponzi thinking and borrow in terms of maximum debt service, a collective insanity.

By 2005, Option ARMs and 100% financing left us with 0% down payments as the cycle reached its ultimate limitation — they were giving it away. Not surprisingly, prices skyrocketed; unfortunately, the terms of the Option ARM were not stable and the Ponzi Scheme blew up. Today, we are back to the 1950s in the world of mortgage finance — and that is a good thing.

The 30-year fixed-rate fully-amortizing loan is the only stable loan product, and a significant down payment is required to keep down speculation. As down payments get smaller, the incentives to speculate with lender money get larger. With no-money-down the incentive to speculate hits infinity. One-hundred percent financing with no qualification is a free-for-all no-limit housing market casino.

Savers gain advantage bidding on real estate

Most buyers don’t have 20% to put down on a home, particularly first-time homebuyers. Most buyers don’t have the current FHA standard 3.5% down either, or we wouldn’t have tried 0% down to begin with. When it is an FHA buyer, they generally only put the minimum 3.5% down. The loan plus the down payment is about 16.5% lower for an FHA buyer than it is for a conventional borrower putting 20% down, assuming both are qualified using the same income and same DTI. Further, the FHA buyer pays a significant insurance premium which cuts into their ability to finance a large mortgage. The same debt-to-income ratio thereby supports a smaller loan balance.

In the real world, the conventional borrower is also utilizing a higher DTI ratio. Instead of being limited to the FHA 31% front end DTI, conventional borrowers are often allowed to go into dangerous waters with 32% to 38% DTI levels. This additional money put toward debt service makes for larger loans. The borrower with enough cash to put 20% down has a significant bidding advantage over the FHA buyer, which is why most home sales in OC are to conventional buyers.

The lower down payment amount and the smaller loan balance make FHA less desirable than conventional financing for borrowers looking to bid up prices. FHA financing can be looked at as training wheels for mortgage borrowers, as most first-time homebuyers use it.

After some period of time in a normally appreciating market (if there is such a thing), the combination of loan amortization and home price appreciation results in home equity exceeding 20% of the resale value of the property. When there is enough home equity that a more expensive house than the borrower’s current home equity, they cross a threshold; they have access to the higher DTIs, and they can borrow more money to take the next step up the property ladder — if they are willing to give up some disposable income to have the house.

In the end, it is not the highly leveraged that gain the upper hand in real estate, it is the savers. The real estate market will always boil down to loan plus down payment. The more money people have saved, the greater their down payment and the more they can bid to compete with others at their income level. The saver always comes out ahead.

During the housing bubble, people had access to 100% financing, so few were saving for a down payment. After the housing bubble, the Great Recession caused many people to dip into savings just to make ends meet. Further, since the federal reserve lowered interest rates to zero, beyond the emotional need for reserves for stress reduction, people had little or no incentive to save.

The end result of these circumstances is that very few potential homebuyers have the necessary down payment, even the paltry 3.5% required by the FHA. And since renters put a large percentage of their income toward rent, even if they wanted to endure 0.2% savings interest rates, they don’t have the disposable income necessary to save for a down payment. There is no magic bullet or simple solution to this problem.

Perhaps it’s “old school” and unfashionable in our modern era of unlimited entitlement, but the only way to save for a down payment is for potential homebuyers to sacrifice current consumption and adjust their finances to live within the constraints of their income.

Adjusting finances

People can adjust to whatever income and expenses they have if given a little time. Transitioning from renting to home ownership shouldn’t be a difficult adjustment if you follow a few simple guidelines for structuring your finances while you’re still renting. To make the adjustment, you need to carefully budget for saving for a down payment and making the house payment once you purchase. Fortunately, this is not as difficult as some imagine.

PITI

The first task is to figure out how much you will have to spend each month when you own your home. Lenders don’t pity borrowers, but they are very concerned with an acronym called PITI, a formula they use to calculate the maximum monthly payment you can afford. PITI is short for principal, interest, taxes and insurance, but it also includes other known costs such as HOA dues and mortgage insurance. When a lender calculates the maximum loan they will extend a borrower to buy a particular property, they start with the borrowers income and apply the maximum debt-to-income ratio, currently 31%. They take this number and divide it by 12 to come up with a maximum PITI.

For example, let’s say a borrower making $100,000 per year wants to buy a home. The lender will allow them to put $31,000 per year ($100,000 x 0.31) or $2,583 per month to cover PITI. This number is very important because it tells you how much you can expect to write checks for each month if you max out your loan (most do) to buy a home.

Rent and Savings

As a renter hoping to buy, you must adjust your lifestyle to fit within your PITI amount. Your current rent should be far enough below this figure to allow you to save money for your down payment. But how much below? What is a good guideline for determining the maximum rent you should be paying each month? This is an important question because if you base your selection of a rental based on the PITI of your ultimate cost of ownership, you will also become accustomed to living in the quality of home you will ultimately afford to purchase. Fortunately, there is a formula to figure this out.

I’ve run the cost of ownership calculations on thousands of properties. The monthly cost of ownership is generally 25% to 30% below PITI. This monthly cost of ownership relates to rental parity, the foundation of housing market values.

If you use that guideline, a renter making $100,000 a year should be paying about $1,900 in rent and saving about $700 per month toward a down payment. That translates to a 23% rent-to-income ratio. Anyone with the discipline to live this way will be able to save for a down payment and comfortably transition to home ownership. Anyone who doesn’t have the discipline to live this way may not be cut out for home ownership.

From the above example, a $440,000 conventional loan balance leaves a $110,000 down payment to purchase a $550,000 house. Notice that 3.6% interest rates allow borrowers to purchase at price-to-income ratios of 5.5. That’s very high by historic standards.

It only takes 20 months to save for a down payment

At $700 per month, it will take 158 months to save the $142,052 for a down payment. Thirteen years is a very long time. That’s why so many people opt for FHA financing with 3.5% down. At $700 per month, it only takes 20 months, or just over a year and a half, to save the $13,825 required to cover the FHA down payment on a $395,000 property.

Did you notice the catch to using FHA financing? People who don’t have a 20% down payment have to settle for much less house on the same income. This is why the tradition of buying a starter home, waiting until it accrues 20% equity, then selling for a move-up is such a big part of our housing market.

The bottom line

To prepare for home ownership, rent a property using 23% or less of your gross income. Save 8% of your gross income in a special down payment account you don’t raid for other lifestyle expenses or purchases. In less than two years, you will have the down payment to purchase a property comparable to your rental using FHA financing.

With the discipline you gained from living within your means and saving for a down payment, you will succeed as a home owner and build equity through paying down a mortgage. You might even be rewarded by the appreciation fairies and complete a move-up once you have about 30% equity in your home and you can sell, cover the closing costs and still have 20% for a down payment on a nicer property.

30 responses to “How down payment requirements impact house prices”

Quill Realty is dropping out of the Northwest Multiple Listing Service.

Managing Director Craig Blackmon said he believes his two-person Seattle company is the first in the region to do so. The NWMLS aggregates and publishes all homes for sale for member real estate agents to access.

Multiple Listing Services across the country are widely considered to be the most reliable and accurate sources for real estate listings. Companies such as Seattle’s online real estate company Zillow have faced criticism for not using the service and having out-of-date information.

Zillow is now picking up MLS feeds by the hundreds from across the country to improve the accuracy of its listings.

But Quill Realty sees a major advantage for sellers by leaving the MLS. The new terms could make it more attractive for sellers to list a house — especially important in Seattle’s hot housing market where supply is not keeping up with demand.

Bush demonstrates ignorance to housing issues

Earlier this week Jeb Bush, who has not officially announced that he’s running for the Republican nomination for the office that his father and brother held, said at a small fundraiser that he believes the 30-year-mortgage is likely in decline, that Fannie Mae and Freddie Mac need reform, and that the current housing and debt system is unsustainable.

The following is from a rough transcript recorded by a local Fox News affiliate and obtained by HousingWire, and it shows Bush does think housing policy is a priority.

“I think the system we have needs to be reformed for sure,” Bush told those at the informal gathering in New Hampshire. “(I) worry as much about the people who have lost their homes as lost value of their homes. Home values dropped by 30-40% and they keep making their mortgage payments. It’s an issue of equity.

“I think Freddie and Fannie need to be reformed,” he said. “We’re creating the same bubble that got us in this mess beforehand.”

Bush made a point about the changing demographics in housing, and how it affects housing finance.

“I don’t think we’ll ever get back to the 30-year fixed-rate mortgage,” Bush said. “If you add up the contingent debt that us has required through housing, student loan program…and then you take the contingent of social security, … it’s in to the $50-60 trillion dollars. If we allow that to exist…don’t recast these liabilities, that’s not sustainable. Our children and grandchildren will end up paying all the largess that we allow them to have.”

It’s hard to understand what he’s talking about here. To the average reader/listener that doesn’t follow housing & finance issues, I’m sure it sounds very intelligent. It’s almost as if a campaign pollster told him that people have angst about housing, so he should frame it as something unsustainable when talking about it. No substance just pure rhetoric.

The Mortgage Bankers Association’s (MBA) Weekly Mortgage Applications Survey found that mortgage applications are down 1.5 percent from last week. Freddie Mac also released the results of its Primary Mortgage Market Survey (PMMS), revealing that the average fixed mortgage rates moved just slightly lower following three consecutive weeks of increases.

The seasonally adjusted purchase index decreased 4 percent, the lowest level since April. The unadjusted purchase index experience a 4 percent drop and was 11 percent higher than the same week one year ago.

“Mortgage rates increased last week, and Treasury rates increased to a recent high at mid-week before falling at the end of the week,” said Mike Fratantoni, MBA’s chief economist. “Overall purchase activity fell for the week, along with conventional refinance volume, but government refinance volume increased. The level of purchase applications remained 11 percent higher than the same week last year, but the drop this week may indicate borrowers being wary of the recent run up in mortgage rates.”

The Freddie Mac Primary Mortgage Market Survey (PMMS), found that 30-year fixed-rate mortgages (FRM) averaged 3.84 percent with an average 0.7 point for May 14, 2015 to May 21, 2015. This is a drop from last week’s average of 3.85 percent. The 30-year FRM averaged 4.14 percent one year ago at this time.

I made car payments from 2002 to 2006 because they gave me a 0% loan. Despite believing this was “sophisticated” financial management, I would never do that again. Having no car payment is more valuable in terms of peace of mind and flexibility than the few pennies in interest-rate arbitrage I earned.

Full disclosure – We have two car payments. The reason is the topic of today’s post. We’re saving for a full down payment. The cars’ values are a very small percentage of our income and the rates are negative adjusted for inflation.

If it’s part of a broader financial plan you are executing, then it makes sense. I simply grew tired of the monthly payments, and there were times when I would rather have spent that income on something else.

For people capable of thinking about it in terms of opportunity cost, it can make sense, but probably 80% of buyers do it with only one concern – the size of their monthly payment. As long as they can “afford” it, they don’t care what the terms are. That’s why so many get stuck with a high interest loan with a 7-8 year term, or even worse… a lease.

When I wrote a check for my wife’s car, it was painful; however, the pain was forgotten, and I never regretted paying cash. When I financed those cars in 2002, I felt pain every month when I wrote the checks. Even though I paid the same amount over time, it would have been much less painful had I written one large check up front.

When you are writing a large check upfront you also gain a psychological advantage. You are less likely to over pay for the car and/or buy more car than you can afford because you have to pay the entire amount upfront. They can doctor those payments so it’s financial death by a thousand paper cuts.

That is very true. I bought a 2005 car in 2012 with 125,000 miles on it because I didn’t want to spend so much money. If I had financed it, I might have been tempted to spend an extra $10,000.

Plus, I asked myself how much money I was willing to light on fire with depreciation. If you take the purchase price and divide it by 100, it gives a good approximation of how much value the car loses each month. I wasn’t willing to waste more than I spent, particularly when I considered the depreciation.

I hate car payments as well, but we financed our two most recent purchases. The finance terms are good, but not great….1.9% stretched out over 6 years. However, I make extra payments to the auto accounts so that I will have them paid off sooner. I know it makes little financial sense to purchase new cars, but we are two working adults with little kids. We need fairly reliable cars because there is very little wiggle room in our schedules to accommodate pit stops at the repair shop. New cars don’t require much more in the way of maintenance other than oil changes for the first 75k miles. Also, we have a history of keeping our cars for about 7 years on average.

The point I am trying to make is that sometimes you just have to bite the bullet and buy new knowing that depreciation will render the car worthless. We just try to focus on cars that get us from point A to point B with some degree of comfort.

I can’t wait until the kids are old enough to cart themselves around and I can go back to driving a used pick up truck with no payments.

Despite stagnating incomes, record low home-ownership, surging interest rates, and stalling employment data, home-prices in America rose 5.04% YoY in March – the biggest jump since August – as overseas money floods into American real estate and crushes the affordability dream for Hillary’s ‘everyday American’. No surprise, San Francisco and Denver reported the highest year-over-year gains, with price increases of 10.3% and 10.0%, respectively, over the last 12 months. This is the highest home price index since Feb 2008.

More pain ahead

LONDON, May 26 (Reuters) – Gold dipped almost 2 percent on Tuesday as the dollar extended gains following a raft of strong U.S. data and recent comments from Federal Reserve Chair Janet Yellen that reinforced the central bank’s tightening bias on monetary policy.

Spot gold dropped to a two-week low of $1,185.35 an ounce earlier and was down 1.6 percent at $1,187.59 by 1413 GMT.

U.S. gold futures for June delivery were down $16.70 at $1,187.30 an ounce.

The dollar continued its strong run, up 1.2 percent against a basket of leading currencies, after data showed U.S. business investment spending plans increased solidly for a second straight month in April.

“We maintain the view that the third quarter is likely to be the weakest quarter for gold, given that we expect the Fed to start increasing rates in September, but the potential downside is likely to be limited,” it said.

Warren Buffett advocates a “major and carefully crafted expansion of the Earned Income Tax Credit” over raising the minimum wage in a Wall Street Journal commentary published Friday, saying this is a “better answer” to the widening economic gap between those living the American dream and those living an “American Nightmare.”

Any plan to increase the minimum wage “would almost certainly reduce employment in a major way,” he writes.

“In essence, the EITC rewards work and provides an incentive for workers to improve their skills. Equally important, it does not distort market forces, thereby maximizing employment.”

He suggests several ways to improve the EITC, including stiffening penalties for fraud, and instituting monthly payments instead of annual.

“In essence, the EITC rewards work and provides an incentive for workers to improve their skills. Equally important, it does not distort market forces, thereby maximizing employment.”

Increasing the EITC does not DIRECTLY distort market forces. Some distortion is an unavoidable result of any change. But the money has to come from somewhere, or someone.

I understand what Buffett is saying about the effect of raising the minimum wage. It will cause employers to eliminate money-losing positions, and replace them with less expensive automation or move the jobs to less expensive offshore job centers. This is already happening without raising the minimum wage. Any increase will only accelerate the process.

But, the EITC is funded by taxes on income, corporate taxes, and dividend and capital gains taxes. Increasing any of these will DIRECTLY affect market forces like profit, stock prices, and consumer spending. The hope is that the increase in the EITC will partially offset the loss from rising taxes on the wealthy and a drop in spending by the wealthy. The EITC is once removed from directly impacting profits and prices, but it will affect them nonetheless.

The impact will vary depending on which part of the market you are targeting. Lexus sales will fall but Toyota might see a banner year with a higher EITC.

But, there is already an incentive for improving your skills: it’s called higher income. If the government wants to create incentives, they could start by cutting marginal tax rates. How about a cap on taxes? Maybe tax the first 50k of income at 40% and everything after that is tax-free. Or even reducing amount of income tax above a certain level to a floor for the mega rich.

We would have the hardest working workforce on the face of the planet. You could even range it and say income is taxed at 40% from 50-100k, outside of that, no taxes. We would have some portion of the population that can never attain the skills to earn more than 50k, so they pay no taxes. The middle class would disappear, though. Who would the politicians pander to then?

If something must be done to address the growing disparity in income and wealth, then it should be done from the perspective of encouraging hard work and rewarding those who engage in it. Blindly raising the minimum wage, discourages those with little or no skills from working to develop them, and punishes those who have.

The saddest thing about this is that raising the minimum wage won’t improve the lives of these workers. Their real income will fall, precipitously for those who lose their jobs. Those that somehow avoid the axe will just see price inflation take away any gains they see in their gross incomes.

The erosion of buying power due to inflation will be particularly pronounced here in California as rising rents will eat up most of the raise because many renters will take most of this raise to improve their housing situation, bidding up rents in the process.

Kool-aid freely flowing in LA

The building, proposed to the city Planning Commission on Thursday, would rise 37 stories at the southwest corner of Grand Avenue and 12th Street. The tower would have 126 units, which shouldn’t be hard to sell, developer Joseph Lin said.

“Downtown still has a lot of potential to grow,” said Lin, managing partner of City Century, the Los Angeles subsidiary of Shanghai real estate developer ShengLong Group.

Only about 10% of the more than 500,000 people who come to work downtown every day live there, Lin said. That’s a far smaller percentage than in San Francisco or Seattle, even though housing is less expensive in downtown Los Angeles, he said.

Lin intends to price his units between $600,000 and $4 million, or about $1,000 per square foot. New condos in San Francisco cost more than $1,250 a square foot, according to real estate marketing firm Mark Co.

The only new condos being sold in downtown Los Angeles are still under construction in the Metropolis complex north of L.A. Live, according to Mark Co. They also cost about $1,000 a square foot.

Mark Co. founder Alan Mark estimates that downtown has less than two months of condo supply on sale now, far less than the six-month benchmark typically considered a sign of a balanced market.

Multiple residential projects are in the pipeline, but Mark predicts that demand for units will remain high.

“Many developers want a piece of downtown,” he said. “It’s beyond a viable place to live — it’s really reached a critical mass.”

$4 million to live in the ghetto. Imagine that. It’s nice to see the Chinese finally importing the “vacant city” concept to the US. Their economy has grown by double digits thanks to unnecessary construction and now it looks like we get to enjoy that same mis-allocation of capital!

We have problems with a chronic shortage of housing in California, so if the Chinese come in and build unnecessary housing that isn’t cost effective, it will add much needed supply that may serve to lessen pricing pressure in other locations.

The focus should be on the loan-to-value, not down payment. If the goal is to maintain adequate security for the loaned capital, there should be a sliding down payment based on the average of the current house value plus the last 2 years.

The most that could be borrowed would be either 90% of the avg home value over 3yrs or 80% of the current value. That way, when home prices are stable (i.e. 0% appreciation), then 10% would be allowed. If home prices are appreciating rapidly, then 20% would be required. If home prices are falling, then less than 10% would be required.

An appropriate maximum LTV of 95% could be added in times of falling prices.

This would even out the cycle by reducing demand as prices rise and increasing demand as prices fall. Plus it actually makes sense.

I like the idea, but can you imagine how much people will complain when the punch bowl is removed due to rising down payments? Just as the kool-aid intoxication is making everyone want to buy, the higher down payment requirements would prevent them from doing so. While the mechanism would work, and it would be a great thing for the market, the complaints would make it politically very challenging to implement.

The art of politics is doing the right thing without anybody knowing it. This would have to be sold as a reduction in down payments, not an increase. Since lower down payments would be the rule unless prices rose dramatically, this is in fact true (10% nominal down vs 20%). Or at least sounds true, which is close enough for politics.

Better still, focus on the amount loaned, not the down payment. The amount loaned can only increase in proportion to a running average. Say that appraisals are highly suspect (which they are) and provide unreliable market estimate of value. Then shift to castigating sellers for over-inflated prices. This has nothing to do with down payments!! 😉

And, if you can get the blindly loyal to shout down the militantly opposed, the rest can be swayed by earmarks.

People always complain about something. Right now, people are complaining that prices are too high. The same people are complaining that rates are also too low! Taxes are too high, unless of course you don’t pay them, then they are too low.